The credit derivatives market continues to expand at a remarkable pace while concern grows about how the market would deal with an eventual downturn, according to a new report from Fitch Ratings.

The total amount of credit derivatives bought and sold reached nearly US$50 trillion at year-end 2006, an increase of 113% over the US$23.4 trillion reported for year-end 2005, the rating agency reported.

“Leading the charge for the growth in the credit derivatives market are the traded indices, which, for the first time, surpassed single-named CDS in volume last year, even though single-name usage itself continued to expand rapidly,” said James Batterman, senior director, and co-author of Fitch’s fifth annual Global Credit Derivatives report. The agency estimates that US$22.2 trillion of index products was bought and sold by year-end 2006, compared with US$20 trillion in single-named CDS.

Despite the current benign corporate credit environment, a number of market participants expressed concern for how smoothly the market can deal with an eventual downturn in the credit cycle. Specifically, some of these worries included liquidity in the event of a downturn, the impact that unwinding of system leverage can have on volatility, and settlement following a credit event.

Nonetheless, survey respondents expect the CDx market to continue its expansion, with CDOs, LCDS (Loan-only Credit Default Swaps), and the traded indices cited as the biggest growth vehicles for 2007. “The growth of the indices has been well-documented since their introduction, and as is clear from the figures, this expansion has continued unabated,” says Eric Rosenthal, director, and co-author of the report.

On the surface, banks globally appear to have become somewhat more conservative in terms of their credit exposure, Fitch said, ending 2006 at US$304 billion net protection bought, although 20 of the 44 banks surveyed, or 45%, were net sellers of protection. ‘Trading’ was again cited as the leading rationale for employing CDx.

“The increase in gross sold positions (120% from year-end 2005 figures) was influenced by the larger intermediation role played by banks and broker-dealers in meeting investors’ demand for portfolio diversification, enhanced yield, and general preference for increased structural complexity and leverage,” noted Krishnan Ramadurai, managing director, and co-author of the report. The global insurance and monoline industries continued to be key net sellers of protection at US$395 billion and US$355 billion, respectively, at year-end 2006.